“We have met the enemy and he is us.”
Pogo, popular comic strip character of 1960’s and 1970’s
You will see below that we divide this commentary into two sections: Market Commentary and Planning Commentary. We do this because we think each is equally important in achieving our clients’ wealth management goals.
PLANNING COMMENTARY
The passing of April 15 reminds us of how important tax planning of all forms is in building wealth plans for our clients. The Economic Growth and Tax Reform Reconciliation Act of 2001 (otherwise known as the “Bush tax cuts”), reduced income tax rates substantially and changed a number of other taxes such as capital gains and the federal estate tax. As part of the Act, “Clinton-era” tax rates were scheduled to be reinstated or “sunset” starting 1/1/2011 as a way to stay within PAYGO rules. If Congress does nothing, top income tax rates will return in 2011 to 31%, 36% and 39.6% (versus current 28%, 33% and 35% respectively). Also the maximum long-term capital gains tax of 15% presently would revert to 20% while the tax on dividends would go from 15% presently to be taxed as ordinary income with maximum tax rate of 39.6%. This all seems quite possible as it would allow current leaders to blame past leaders for the tax increases yet still reap the benefits of increased revenue.
In addition to income tax rates that are scheduled under current law to increase, the Health Care and Education Reconciliation Act of 2010 imposed a special Medicare tax equal to 3.8% on certain taxpayers with taxable investment income (to start in 2013). The tax will be imposed on certain investment income over Modified Adjusted Gross Income limits ($250,000 for Married Filing Joint taxpayers) and will certainly amount to a considerable tax on wealthier individuals.
Most recently economists and tax experts have been whispering about the potential for a Value Added Tax (VAT) as a way to generate more tax revenue (this acts similar to a national sales tax). All these taxes are in addition to what is being paid in a number of other forms (state sales tax, gasoline tax, real estate and property taxes, etc.) and will be increasingly important in fueling entitlement programs promised by our government.
The reason we point out these current and potential tax changes is to remind ourselves and our clients of the importance in having a meaningful plan to deal with these tax-related headwinds. Only through purposeful and truly comprehensive wealth planning is one able to envision strategies that can help their family protect their future against risks like these.
MARKET COMMENTARY
The stock market strengthened in April as corporate profits grew and investors became more convinced of the sustainability of the economic recovery. As we write this, the S&P 500 has returned 2.0% in the month of April and 7.4% year-to-date (through April 28). Further, investors who didn’t sell during the credit crisis are seeing their accounts move closer to the levels before the 2008 credit crisis and are becoming increasingly more confident.
While we are glad to see accounts recovering, our views are toward wealth preservation at least as much future market gains. There are many concerns, including the debt levels and budget deficits of U.S. and other developed countries. The U.S. dollar and other currencies are not backed by gold or silver (as was the case at points in the past), but instead by confidence in the issuer’s economy. Unfortunately the fiscal policies in the U.S. may not continue to instill sufficient levels of confidence and we believe it is most likely that the U.S. currency will fall over time as compared to those countries who act in a more responsible fiscal manner. It is popular sport in America to blame our politicians, however those same politicians merely are a reflection of the general electorate—and sadly the electorate has shown no willingness to accept the shared sacrifice (of entitlement cuts and tax increases) necessary to restore fiscal health. Thus the quote to start this letter: “We have met the enemy and he is us.”
Given our concerns about the U.S. fiscal policies, we are increasing our client portfolio positions in emerging markets bonds. These emerging countries do not have the high public debts (as compared to GDP) of the U.S. and other developed countries, nor do they generally have the structural budget deficits. We are funding this emerging bond increase with reductions in U.S. dollar denominated investment grade bonds. We recognize that these emerging market bond positions would suffer if we had another market similar to 2008 when money fled to the perceived safety of the U.S. dollar; however our belief in the story for long-term dollar weakness is so strong that we would very likely use such an occurrence to further build emerging market stock and bond positions.
We are not diversifying further into currencies of other developed world countries (like U.K., France, Japan) because we think their fiscal problems are as bad or worse than the U.S. (with the exception of Germany). One merely needs to read current headlines of bond downgrades in countries like Greece, Portugal and Spain to get a feel for these problems.
